The B-BBEE regulations as they stand since 24 October 2014 have raised the bar from previous versions in terms of transformation and are forcing companies to seriously re-consider their B-BBEE-strategies. This message is not new, but as companies settle for new strategies, it becomes clearer where companies are exploiting grey areas or even where new patterns of fraud emerge.
Areas of concern
Two areas that contribute significantly to a company’s B-BBEE rating are Ownership (25 points) and Enterprise and Supplier Development (30-40 points).
Since Enterprise and Supplier Development (ESD) is not an applicable area for smaller companies (EME) and is not as significant for medium-sized companies (QSE) these entities are mostly focusing on ownership structures – and this is where things are getting interesting…
The “courtesy” that has been extended to EME’s and QSE’s allows them to capture and present their B-BBEE statuses using only an affidavit. This has essentially made B-BBEE compliance an honesty system. The fact that PwC’s Economic Crime Survey for 2018 has once again awarded South Africa the questionable honor of the “champion” of economic crime points to the risks inherent in this approach. Until recently at least questions of integrity extended all the way to the very top of the country’s leadership…at the same time companies are desperate for business in an economy that is still struggling to live up to growth expectations and the pressures of socio-demographic dynamics.
In this light, a system based to a certain degree on self-policing and self-reporting bears significant risk – especially considering the penalties for any breaches even for customers of fraudulent entities. So any counterparties to EME’s and QSE suppliers should be cautious of telltale signs of fraud.
4 relevant “schemes”
The following list of fraud patterns is by no means exhaustive, but they definitely feature heavily in investigations conducted by data collection and verification service providers like Inoxico:
1. Misrepresenting Information
Let’s start with the most basic (and desperate) form of BEE fraud: falsification of data or certificates. Here, two main modus operandi stand out:
A. Manipulating details on a certificate that was issued under the previous codes in order to extend its validity period. Picking this up typically requires detailed knowledge of the layout and various elements of the certificates, good relationships with the verification agencies and access to historical data and certificates.
B. Misrepresentation as a QSE or EME, when based on the company’s revenue it qualifies instead as a Generic. Getting to a high B-BBEE rating is in most cases much easier for EMEs and QSEs. In terms of spotting misrepresentation, it is sometimes as easy as triangulating different types of information on vendor companies, e.g. comparing customer contracts with B-BBEE information.
2. Promoting Straw Men
Promoting employees to directors without the proper rights and remuneration is nothing new, but definitely still relevant. Companies take advantage of certain employees’ ignorance in terms of what it means to be a director of a business. They “promote” black employees to director/shareholder level without them taking on the duties of a director/shareholder or aligning their remuneration schemes with these titles. This improves their management/ownership credentials in terms of BEE, but the relevant employees are “chewed up and spat out” in the sense that this title is taken away as soon as the business has made an alternative plan – and this is certainly not in the spirit of the act.
Examples date back to 2015: Zevoli Industrial Supplies Fronting Case
3. Impermissible Flow through
The current B-BBEE codes allow for something referred to as the modified flow-through principle, which entails the use of a Special Purpose Vehicle (SPV) as part of the company’s ownership structure. It provides for an easier means to improve a company’s black-ownership credentials by using a >51% black-owned SPV as a 100% black-owned shareholder.
In addition to the above and as already mentioned, in an effort to lower the cost of compliance for small businesses, the Act allows EMEs and QSEs to formalise their B-BBEE rating by simply completing an affidavit under oath.
Combining these two principles, however, is deemed to be against the spirit of the act and a misrepresentation of B-BBEE credentials, as per the B-BBEE Commission’s Practice Guide 01 of 2017. QSE’s and EME’s cannot claim to be >51% black-owned if the relevant shareholder is an SPV, using the modified flow-through model. This is essentially seen as taking advantage of the “courtesy” extended to small owner-run businesses for the purposes of improving the ratings of larger, more complex, ownership structures.
Similar to the previous “scheme” it is important that purchasers obtain a decent understanding of their vendors and cross reference other vendor information with their B-BBEE information in order to spot contraventions of the above. Although not against the law as things stand, ultimately it will probably be written into the next revision of the Act.
4. “Fake” employee-ownership schemes
Employee-ownership schemes are well known and used for many reasons – one being the improvement of B-BEE ratings. Basically, black employees are given shares in the business to improve the company’s black-ownership percentage.
One version of the above is based on extending equity to black employees through company loans. Conceptually these loans are then paid back by the employees using their shareholder proceeds, e.g. dividends. However, this “system” can easily be manipulated to ensure the relevant employees never really become shareholders.
For example, should the board of directors own the property the company rents, they could easily increase rent to reduce profits and thereby dividend payouts. Which means the short-term shareholder proceeds for these employees would virtually be zero and therefore their ability to pay back the related loans none. One can probably come up with many examples of how profits can be manipulated to the disadvantage of employee-ownership schemes if the business is not well governed – which is often the case for smaller businesses.
What are the implications of being involved or unaware?
As for many other cases of vendor related fraud there are serious implications for perpetrators and stakeholders involved (e.g. procurement officers).
1. The B-BBEE act (section 13O (2)) states that a verification professional, procurement officer or any official of an organ of state or public entity who becomes aware of the commission of, or attempt to commit, any offence referred to under section 13O (1) and fails to report it, is guilty of an offence. Plus, if an entity is found to have violated the Act, an entity could be fined up to 10% of its annual turnover, and individuals involved could be imprisoned for up to 10 years, and or fined. Specifically, an offence under section 13O (2) could lead to imprisonment of up to 12 months, or a fine, or both.
2. It is important to remember that the SA Companies Act (via the OECD regulations), the UK Bribery Act and the FCPA all require companies to put adequate measures in place to prevent fraud and corruption, and some speak specifically to 3rd party related fraud. Should directors and those accountable not do so, they can be held personally liable.
How to address the problem
On-Boarding and Monitoring
As part of a well-constructed Supply Chain Governance function, vendor B-BBEE statuses should be assessed and validated during the vendor on-boarding process and at regular intervals thereafter (typically when statuses are renewed). This should be done in conjunction with assessing other vendor-company data in order to gain a proper understanding of risk.
Any suspicion of B-BBEE fraud should be substantiated by specific B-BBEE fraud related assessments. These range from basic risk assessments using on-file (or vendor-provided) data to in-depth assessments which include ultimate beneficial ownership analysis through site visits.
These processes should also cater for the mitigation of these risks through appropriate interactions with vendors and B-BBEE authorities (e.g. the B-BBEE commissioner) once a risk has been identified.
By having a reasonable and credible process in place that includes the above-mentioned elements, companies operating in SA can operate in full compliance and in the spirit of the act – and effectively contribute to an uplifting social dynamic in the economy.